Some economists believe that a tax-subsidy solution to externalities rarely works effectively and without distortions to the way a market operates. They believe that the free market mechanism offers a better solution.

Pollution permits are a combination of command and control and market-based approaches to the task of limiting pollution emissions. Polluters can bid for a permit that allows them to create a fixed amount of pollution. These permits can be resold: The government can gradually reduce the number (volume) of pollution permits available so that total pollution emissions can be controlled.

·        If you can sell a permit for more than it is worth to you -- you do so

·        If you can buy a permit for less than it is worth to you -- you do so

If a company (X) has a high marginal benefit from pollution emissions – it will be willing to buy some permits from another business (Y) who has a lower marginal benefit from emitting pollution.

Assume initially that both firms X and Y are producing 20 units of a pollutant each from their output. The government may decide that only eighteen units of pollution is permissible for each firm. If firm X manages to reduce pollution emissions to sixteen units it would be a given a credit of 2 units.

This permit could be traded with firm Y – allowing Y to continue producing twenty units of the pollutant. The effect is that total pollution emissions still falls to thirty six units (for the two firms combined) - but the systems of traded permits means that pollution reduction is concentrated in the firms where pollution reduction can be achieved at the lowest cost.

The market for permits will reach a market-clearing price where the marginal benefit of pollution emissions is equal. Businesses can either buy permits or invest in technology to reduce pollution emissions - whichever approach saves them money. Gradually the total amount of pollution allowed can be reduced – as the stringency of pollution limits is tightened, so the value of permits may rise, they will be more valuable to companies that can bring down pollution levels at lowest marginal cost.

Marketable permits have been tried in several countries – including Singapore where an auction mechanism has been introduced for the trading of ozone-depleting substances. For the system to be effective there needs to be common acceptance of the legal framework for the trading of permits and regulation of the amount of pollution produced. The Kyoto Summit on Climate Change (held in December 1997) witnessed a decisive move towards a greater use of internationally traded pollution permits – based on the idea that each country is required to achieve a specific percentage reduction in pollutants such as C02.

POTENTIAL PROBLEMS WITH TRADED POLLUTION PERMITS:

·        How are permitted levels of pollution decided? If based on current production levels they may be no advantage for firms that have already taken steps to control their pollution emissions

·        Traded permits may see pollution being concentrated in certain geographical areas. At the Kyoto Summit, developing countries were not required to make reductions in pollution – but could be given credits for “certified reductions” in pollution that could be then traded with other countries. This might allow countries such as the United States to buy up pollution permits from LDCs (including many form high polluting countries in Eastern Europe) – and avoid the need to reduce pollution themselves

·        There are likely to be high administrative costs associated with monitoring pollution emissions – particularly if the number of firms involved is very large.